PLR 200422003: Corporate spin-off preserves later nonrecognition but triggers earlier asset gains or losses

Plain-English summary

A public corporation planned to separate one business segment through transfers among subsidiaries, conversion of a limited liability company to a corporation, and distribution of the new corporation's shares to its shareholders. The IRS ruled that earlier transfers of specified assets and interests within the group would produce recognized gain or loss, taken into account immediately before the distribution. It treated the conversion and distribution as a section 368(a)(1)(D) reorganization and section 355 stock distribution, with no gain or loss on the specified later contribution or shareholder distribution. The new corporation received carryover asset bases, and shareholders allocated their stock bases between old and new shares. The IRS did not decide whether the transactions had a tax avoidance purpose under sections 267 or 269.

Ruling snapshot

• Question: What recognition and basis rules applied to the preparatory transfers and proposed spin-off?
• Outcome: Approved; early transfers recognized gain or loss, while the later reorganization and stock distribution qualified for nonrecognition.
• Key authorities: IRC §§ 1001, 311(b), 368(a)(1)(D), 355, 361, 362, 358; Treas. Reg. § 1.1502-13.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200422003
Release Date: 5/28/04
Index Number: 311.01-00; 312.00-00;
338.00-00; 355.01-00;
357.00-00; 358.00-00;
Person To Contact:
361.00-00; 362.00-00;
--------------------------, ID No--------------
1502.13-00
Telephone Number:
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Refer Reply To:
-------------------------------------------------- CC:CORP:B06 – PLR-147943-03
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Date:
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February 13, 2004

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LEGEND

Distributing = ----------------------------------
Controlled = --------------------------------------
Corporation A = --------------------------------
Sub AA = ---------------------------------------------
Sub BB = ----------------------------------
LLC aa = ---------------------------------------------
LLC bb = --------------------------------------------------------
LLC cc = --------------------------------------
LLC dd = -----------------------------
State W = -------------------
State X = -------------
State Y = ----------
State Z = ------------
Product xx = -------------
Product yy = ---------------
Facilities = ------------------------------------------------
Active Business = -------------------------------------------------------
Newco’s Assets = --------------------------------------------------------------------- -----------

---------------------------------------------------------------------------------
----------------------------------------------------------------------
Controlled Assets = ---------------------------------------------------------------------------------
-------------------------------------------------------
Active Business
Assets of Controlled = ---------------------------------------------------------- ----------------------
------------
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PLR-147943-03

Date 1 = = --------------------------
Date 2 = -------------------
Business Segment A = ------------------------
a = -----------------
b = -----------
c = ----------------
d = --------
e = ---
f = ---
g = ---
h = ---
i = --------
j = -----
k = -----
l = --------
m = --

Dear -------------

This is in reply to letters dated August 8, 2003, December 17, 2003, January 29, 2004, and February 4 and February 10, 2004 and February 13, 2004, requesting rulings concerning the federal income tax consequences of a proposed series of transactions culminating in Distributing's pro rata distribution of all of the outstanding stock of newly formed Controlled. The information submitted for consideration is summarized below.

Summary of Facts

Distributing (also referred to herein as the Taxpayer) is a publicly-held corporation incorporated in State W on Date 1. Distributing is also the common parent of an affiliated group ("Distributing Group") that files consolidated federal income tax returns. Distributing uses a calendar year as its taxable year and maintains its books and files its federal income tax returns on an accrual basis. As of Date 2, Distributing has issued and outstanding approximately a shares of common stock ("Distributing Stock") held by more than b shareholders and c shares of preferred stock ("Preferred Stock").

The Distributing Group is an integrated provider of Product xx and Product yy throughout the United States and abroad. The Distributing Group provides these and other services through d business segments. Specifically, Distributing has determined that Business Segment A, which involves both (i) the development, operation and management of Facilities and (ii) selling commodities and providing services relating to Product xx and Product yy, should be separated from the other business segments and spun off pro rata to the holders of Distributing Stock. Presently, the domestic assets 3 PLR-147943-03

comprising Business Segment A are held by LLC aa, LLC bb, LLC cc and Sub AA. (“LLC” means limited liability company).

The Distributing Group engages in the development, operation and management of Facilities primarily through LLC aa. The Distributing Group engages in selling commodities and providing services relating to Product xx and Product yy primarily through LLC bb.

LLC aa currently owns and manages e operating and f currently non-operating Facilities, although LLC aa is currently negotiating the sale of m operating Facilities. LLC aa is a State X limited liability company, wholly owned by Sub AA, and is disregarded as separate from its owner. Sub AA is a State Y corporation and a subsidiary of Distributing several tiers removed from Distributing in one of Distributing's chains of subsidiary corporations ("Sub chain 1").

Sub AA owns several subsidiary LLCs, each of which is disregarded for federal tax purposes. Unrelated third-party investors ("Investors") have lent approximately $i million (the "Debt") to one of such subsidiaries, LLC dd: the Debt amount was loaned by LLC dd to other LLCs of Sub AA. Because all of these subsidiary LLCs are owned directly or indirectly by Sub AA and are disregarded for federal tax purposes, the Debt is treated as an obligation of Sub AA for federal tax purposes.

The Debt was incurred to finance LLC aa’s acquisition of several Facilities. It is secured by liens on the Facilities and is also guaranteed by a first-tier subsidiary of Distributing. The Investors will not release the liens or such guarantee; therefore Sub AA must retire the Debt prior to the proposed spin-off. If the Debt is not retired, Distributing’s first-tier subsidiary would be the guarantor of the debt of an unrelated corporation following the spin-off.

LLC bb is a State X limited liability company that is treated as a partnership for federal tax purposes. Sub BB, a member of the Distributing Group, owns g% of the membership interests in LLC bb, the other h% is owned by an affiliate of Corporation A. Sub BB is a State Z corporation and a subsidiary of Distributing several tiers removed from Distributing in Sub chain 2. It is a sister corporation to Sub AA.

Distributing and Corporation A are negotiating with respect to Corporation A's interest in LLC bb, and (i) Sub BB will acquire Corporation A's partnership interest in LLC bb, (ii) LLC bb will be liquidated and its assets distributed pro rata to Sub BB and Corporation A, or (iii) Sub BB will not acquire Corporation A’s interest in LLC bb and LLC bb will not be liquidated. Sub BB's interest in LLC bb, whether comprising g% or 100% of the interest(s) in LLC bb or g% of the assets of LLC bb, is hereinafter referred to as the "LLC bb interests." 4 PLR-147943-03

In order to implement the spin-off, the following transactions are proposed:

1. Sub AA will transfer to LLC aa all of the membership interests in LLC cc,
   which is an entity wholly-owned by Sub AA and is disregarded as separate
   from its owner.

2. LLC aa will form a new State X corporation (“Newco”) and will transfer all
   of its domestic assets other than membership interests in LLC cc and
   several of its subsidiary LLCs and other than the m Facilities currently the
   subject of sales negotiations, to Newco in exchange for (1) all of the
   outstanding common stock of Newco ("Newco Common Stock"), (2) $j
   million par value, nonvoting, convertible, preferred stock of Newco
   ("Newco Preferred Stock"), and (3) one or more Newco notes in the
   aggregate principal amount of up to $k million (the “Newco Note”).
   Moreover, a foreign subsidiary of Distributing may sell a Facility to Newco.

3. Prior to the formation of Newco, LLC aa or Sub AA will have entered into a
   binding agreement with the Investors to sell to the Investors all of the Newco
   Preferred Stock for approximately $j million in cash. This cash, together with the
   amount to be obtained upon LLC aa's disposition of the Newco Note, will be used
   by Sub AA to enable Sub AA to retire up to $i million of the Debt.

4. Sub AA will distribute to its immediate parent all of its membership interests in
   LLC aa (exclusive of the m Facilities currently the subject of sales negotiations),
   which interests will continue to be distributed all the way up to Distributing.

5. Sub BB, a sister corporation to Sub AA, will distribute to its immediate parent the
   LLC bb interests, which will continue to be distributed all the way up to
   Distributing.

6. Distributing will contribute the LLC bb interests to LLC aa.

7. LLC aa will convert from a State X limited liability company to a State X
   corporation under the laws of State X, and all the membership interests in LLC
   aa will be converted into approximately a shares of common stock. (Pursuant to
   such conversion, LLC aa will then be referred to in this letter as "Controlled" and
   its common stock as "Controlled Stock").

8. Distributing will distribute all of the Controlled Stock to the holders of Distributing
   Stock, on the basis of one share of Controlled Stock for each outstanding share
   of Distributing Stock (the "Distribution").
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Distributing will treat the conversion of LLC aa from a State X LLC to a State X corporation as a contribution by Distributing of all of the assets of LLC aa (other than the m Facilities currently the subject of sales negotiations) to a new corporation controlled by Distributing as occurring in connection with a reorganization pursuant to section 368(a)(1)(D) of the Code. Before the Distribution, Distributing will not modify its ownership of the Controlled Stock.

The Distribution will enable the Distributing Group to effect a reduction in federal taxes inasmuch as the Distributing Group will recognize a loss to the extent that the federal income tax basis exceeds the current fair market value of the assets transferred to Controlled, which loss is estimated to be approximately $l million. Taxpayer has indicated that the Distribution would be consummated regardless of whether or not the Distributing Group would recognize a loss by reason of the Distribution.

Representations

Taxpayer makes the following representations:

1. Any indebtedness owed by Controlled to Distributing after the Distribution or
   evidenced by the Newco Note will not constitute stock or securities.

2. No part of the consideration to be distributed by Distributing will be received by a
   shareholder as a creditor, employee, or in any capacity other than that of a
   shareholder of the corporation.

3. The five years of financial information submitted on behalf of Distributing is
   representative of each corporation's present operation, and with regard to such
   corporation, there have been no substantial operational changes since the date
   of the last financial statements, submitted.

4. The five years of financial information submitted on behalf of the Active Business
   of Controlled being transferred to Controlled is representative of its present
   operation, and with regard to such business, there have been no substantial
   operational changes since the date of the last financial statements, submitted

5. Following the transaction, Distributing and Controlled will each continue the
   active conduct of its business, independently and with its separate employees.

6. The distribution of the stock of Controlled is carried out for the following
   Corporate Business Purposes, and the distribution of the stock of Controlled is
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   motivated, in whole or substantial part, by one or more of these corporate
   business purposes:

   a) Business Segment A is no longer a "core" business of the Distributing Group
   and diminishes Distributing's ability to execute its revised strategy.

   b) The greater business risk of Business Segment A potentially jeopardizes
   Distributing's continuing financial ability to pay a generous dividend to its
   shareholders consonant with its revised strategy.

   c) The greater inherent business risk of Business Segment A necessitates
   significantly lower levels of debt as a standalone business and results in lower
   than optimal leverage at Distributing as currently combined.

   d) Business Segment A is currently burdened with overhead costs from
   Distributing that results in a cost structure higher than is deemed appropriate
   for its type of business.

   e) Operation as a standalone business with its own financial reporting and
   separately answerable to the capital markets will better support an ongoing
   restructuring of the Business Segment A. Separation is expected to improve
   information transparency and access to capital markets for both Distributing
   and Controlled, eventually resulting in lower overall capital costs for the two
   entities.

7. There is no plan or intention by any shareholder who owns 5% or more of the
   stock of Distributing, and the management of Distributing, to its best knowledge,
   is not aware of any plan or intention on the part of any particular remaining
   shareholder of Distributing, to sell, exchange, transfer by gift, or otherwise
   dispose of any stock in either Distributing or Controlled after the transaction.

8. There is no plan or intention by Distributing or Controlled, directly or through any
   subsidiary corporation, to purchase any of its outstanding stock after the
   transaction, other than through stock purchases meeting the requirements of
   section 4.05(1)(b) of Rev. Proc. 96-30.

9. There is no plan or intention to liquidate either Distributing or Controlled, to
   merge any of such corporations with any other corporation, or to sell or otherwise
   dispose of the assets of any of such corporations after the transaction, except in
   the ordinary course of business, or as a result of negotiations with Corporation A
   over the future of the LLC bb joint venture.
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10. One or more persons who, directly or indirectly, were the owners of Distributing
    prior to the Distribution will own, in the aggregate, 50% or more of the stock of
    each of Distributing and Controlled after the Distribution.

11. The Distribution will not be a disqualified distribution within the meaning of
    section 355(d)(2) of the Code because immediately after the Distribution (i) no
    person will hold disqualified stock in Distributing that constitutes a 50% or greater
    interest in Distributing, and (ii) no person will hold disqualified stock in Controlled
    that constitutes a 50% or greater interest in Controlled.

12. The Distribution is not part of a plan or series of related transactions (within the
    meaning of section 355(e) of the Code) pursuant to which one or more persons
    will acquire directly or indirectly stock possessing 50% or more of the total
    combined voting power of all classes of stock of Distributing or Controlled, or
    stock possessing 50% or more of the total value of all classes of stock of
    Distributing or Controlled.

13. The total adjusted bases and the fair market value of the assets transferred to
    Controlled will each equal or exceed the sum of the liabilities assumed by
    Controlled plus any liabilities to which the transferred assets are subject; and the
    liabilities assumed in the transaction and the liabilities to which the transferred
    assets are subject were incurred in the ordinary course of business and are
    associated with the assets being transferred.

14. Distributing neither accumulated its receivables nor made extraordinary payment
    of its payables in anticipation of the transaction.

15. No intercorporate debt will exist between Distributing and Controlled at the time
    of, or subsequent to, the distribution of the Controlled Stock, except for possible
    indebtedness of Controlled to Distributing resulting from the limited and/or
    contingent credit support at arm's length pricing and terms that may be provided
    by Distributing to Controlled.

16. Immediately before the Distribution, items of income, gain, loss, deduction, and
    credit will be taken into account as required by the applicable intercompany
    transaction regulations. (See Treas. Reg. §§ 1.1502-13 and 1.1502-14 as in
    effect before the publication of T.D. 8597, 1995-32 I.R.B. 6, and as currently in
    effect; Treas. Reg. § 1.1502-13 as published by T.D. 8597). Further, any excess
    loss account Distributing may have in the Controlled Stock (or in the stock of
    another corporation leaving the Distributing Group in the Distribution) will be
    included in income immediately before the Distribution to the extent required by
    applicable regulations. (See Treas. Reg. § 1.1502-19).
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    PLR-147943-03

17. Payments made in connection with all continuing transactions, if any, between
    Distributing and Controlled, will be for fair market value based on terms and
    conditions arrived at by the parties bargaining at arm's length.

18. No two parties to the transaction are investment companies as defined in section
    368(a)(2)(F)(iii) and (iv) of the Code.

19. Distributing will not receive any money or property from Controlled in
    contemplation of the Distribution (other than in the ordinary course of business).
    However, Sub AA will receive the Newco Note from Newco in connection with the
    transfer of the Newco Assets to Newco.

20. Following the Distribution, there will be no continuing relationships between
    Distributing and Controlled such as common directors, officers or key employees,
    or commonly-owned property. Except for certain limited transition administrative
    functions, there will be no provision of goods and services to Controlled by
    Distributing. However, Distributing may provide limited credit support to
    Controlled and may retain certain pre-existing obligations.

21. Neither Distributing nor Controlled is, plans to become, will cease to be, or will
    become eligible to become a corporation with a special federal tax status.

22. With respect to (i) the transfer of the Newco Assets to Newco in exchange for
    Newco Common Stock, Newco Preferred Stock and the Newco Note, and (ii) the
    transfer of assets by Distributing to Controlled in exchange for Controlled Stock,
    neither transaction is an acquisition described in section 269(a)(1) or (a)(2) of the
    Code the principal purpose for which is evasion or avoidance of Federal income
    tax within the meaning of section 269(a) of the Code.

23. The Distribution is not engaged in or structured with a principal purpose to avoid
    the purposes of section 267 of the Code (including, for example, by avoiding
    treatment as an intercompany sale or by distorting the timing of losses or
    deductions), within the meaning of Treas. Reg. § 1.267(f)-1(h).

24. The gross assets of the trade or businesses relied on to satisfy the active
    business requirement of § 355(b) for both Distributing and Controlled will have a
    fair market value that is 5 percent or more of the total fair market value of the
    gross assets of the corporation directly conducting the trades or businesses.

                                    Rulings
    

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    PLR-147943-03

Based solely on the information submitted by the Taxpayer, we rule as follows on the above described transactions:

1. Sub AA will recognize gain or loss on each of the Newco Assets that LLC aa
   transfers to Newco in an amount equal to the difference between (a) the fair
   market value of such asset and (b) the adjusted basis of such assets. Section
   1001 of the Code; Treas. Reg. § 1.338-3(b)(3)(iv), Example 1; and Rev. Rul. 79-
   70, 1979-1 C.B. 144.

2. Sub AA will recognize gain or loss on each of the Controlled Assets that LLC aa
   holds when Sub AA distributes the LLC aa membership interests to its immediate
   parent in an amount equal to the difference between (a) the fair market value of
   such assets and (b) the adjusted basis of such assets. Sections 1001 and
   311(b) of the Code; Treas. Reg. § 1.1502-13(f)(2)(iii).

3. Immediately prior to the Distribution, Sub AA will take into account the gain or
   loss on each of the Newco Assets that LLC aa transfers to Newco and each of
   the Controlled Assets that LLC aa holds when Sub AA distributes the LLC aa
   membership interests to its immediate parent. Treas. Reg. §§ 1.267(f)-1(c) and
   1.1502-13(d).

4. Sub BB will recognize gain or loss on the transfer of its LLC aa interests to its
   immediate parent in an amount equal to the difference between (a) the fair
   market value of the LLC aa interests and (b) the adjusted basis of the LLC aa
   interests. Sections 1001 and 311(b) of the Code; Treas. Reg. § 1.1502-
   13(f)(2)(iii).

5. Immediately prior to the Distribution, Sub BB will take into account the gain or
   loss on the transfer of the LLC aa interests to its immediate parent. Treas. Reg.
   §§ 1.267(f)-1(c) and 1.1502-13(d).

6. The conversion of LLC aa from a State X limited liability company to a State X
   corporation will be treated as a contribution by Distributing of all of the Controlled
   Assets to Controlled, which contribution, followed by the distribution of the
   Controlled Stock by Distributing pro rata to the holders of Distributing Stock, will
   constitute a reorganization within the meaning of sections 368(a)(1)(D) and 355
   of the Code. Accordingly:

     a. No gain or loss will be recognized by Distributing upon the contribution of
        the Controlled Assets to Controlled in exchange for Controlled Stock and
        the assumption of liabilities. Sections 361(a) and 357(a) of the Code.
   

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   PLR-147943-03

   b. No gain or loss will be recognized by Controlled upon the receipt of the
      Controlled Assets in exchange for Controlled Stock and the assumption of
      liabilities. Section 1032(a) of the Code.
   
   c. Controlled's basis in each of the Controlled Assets will be equal to the
      basis of such asset in the hands of Distributing immediately prior to the
      deemed contribution of the Controlled Assets to Controlled. Section
      362(b) of the Code.
   
   d. Controlled's holding period for each of the Controlled Assets will include
      (a) the period during which Distributing held such asset and (b) the
      periods during which Sub AA and Sub BB (and all corporations starting
      with the parent corporation of Sub AA up to Distributing and starting with
      the parent corporation of Sub BB up to Distributing) held such assets.
      Treas. Reg. § 1.1502-13(c)(1)(ii); Section 1223(2) of the Code.
   
   e. No gain or loss will be recognized by Distributing upon the distribution of
      Controlled Stock. Section 361(c) of the Code.
   
   f. No gain or loss will be recognized by the Distributing shareholders (and no
      amount will be included in the income of any of them) upon receipt of the
      Controlled Stock. Section 355(a)(1) of the Code.
   
   g. The aggregate basis of the Distributing Stock and the Controlled Stock
      held by each Distributing shareholder will equal the aggregate basis of
      each such shareholder's Distributing Stock immediately before the
      Distribution, allocated between the Distributing Stock and the Controlled
      Stock in proportion to the fair market value of each in accordance with
      Treas. Reg. section 1.358-2(a)(2). Section 358(a), (b) and (c) of the
      Code.
   
   h. The holding period of the Controlled Stock received by Distributing's
      shareholders will include the holding period of the Distributing Stock with
      respect to which the distribution is made, provided that such Distributing
      Stock is held as a capital asset on the date of the distribution. Section
      1223(1) of the Code.
   
   i. Proper allocation of earnings and profits between Distributing and
      Controlled will be in accordance with Treas. Reg. sections 1.312-10(a)
      and 1.1502-33(e).
   
                                 Caveats
   

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   PLR-147943-03

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed as to whether either (i) the transfer of the Newco Assets to Newco in exchange for Newco Common Stock, Newco Preferred Stock and the Newco Note, or (ii) the transfer of assets by Distributing to Controlled in exchange for Controlled Stock, constitutes an acquisition described in section 269(a)(1) or (a)(2) of the Code for which the principal purpose is evasion or avoidance of Federal income tax within the meaning of section 269(a) of the Code. Moreover, no opinion is expressed as to whether any of the proposed transactions is engaged in or structured with a principal purpose to avoid the purposes of I.R.C. § 267, including distorting the timing of losses or deductions.

Procedural Statements

This ruling is directed only to the Taxpayer (i.e., acting for its own behalf and as agent for all the current members of the Distributing Consolidated Group) requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Sincerely,

Steven J. Hankin
Steven J. Hankin
Senior Technician Reviewer, Branch 6
Office of Associate Chief Counsel
(Corporate)